Author: Ryan Kimes, CFP®
Saving for retirement is one of the focal points of comprehensive financial planning, yet it is also one of the most uncomfortable subjects for individuals to discuss when meeting with an advisor. Frequent one-liner excuses from generation X and Y clients include, “I’m too young to be thinking about retirement”, or, “I don’t make enough money to be saving right now”. Sure, anyone can relate to these points, but one of the greatest values in financial planning is understanding the time value of money, and the relationship between compounding interest and intervals of time.
Let’s jump into some technical calculations for just a moment. When calculating the future value of an investment, we perform a calculation using the following formula:
Here, C represents a cash flow (our investment), r is the rate of return (or internal rate of return), and n is the number of periods of time. With time (n) being the exponential variable, the future value of the cash flow will have the greatest impact from a change in the number of periods invested (length of time invested). An example of this concept is illustrated below on an investment of $1.
Why does this occur? Because of compounding interest relative to time. Compounding interest is interest growing on interest. Given more intervals of time, this interest will have time to compound on itself and produce additional compounding interest as years pass (^n=intervals of time), exponentially increasing the future value of our investment (C = cash flow).
With working Americans purchasing about $1,100 worth of coffee per year, according to a study by Acorns Money Matters, it’s pretty difficult to say the average person does not have the means to save even $50 per month. Remember, the goal of this article is to articulate the value of time and its impact on your investments, regardless of the amount saved. Let’s take this concept and calculate time’s true value given various assumptions.
The current annual contribution limits for traditional and Roth IRA’s are $5,500 per year ($6,500 for ages 50+). This equates to about $458.33, but for the sake of simplicity we will round our savings to $450 per month. The above table applies the previously discussed future value equation to our cash flows to calculate the future value of our monthly investments, given an 8% annual growth rate.
Using this example, if a 37 year old individual saved $450 per month for retirement (at full-retirement-age of 67), for 30 years, and earned an annual rate of return of 8%, they would have a portfolio value of $675,133. Now, had the same individual started at 27, saving for an additional 10 years, they would have a portfolio value of $1,581,427. That’s a difference of $852,294 in compounding interest alone ($1,581,427- $675,1533 - [$450 per month x 12 months x 10 additional years]) = $852,294. The additional years of compounding interest on top of compounding interest allows the portfolio to grow exponentially greater than the 30-year savings plan, purely thanks to the time value of money. Do you still think it’s still too early to be thinking about retirement? What if the additional $852,294 in growth was grown tax-free through a Roth IRA? Now that’s a reason to start planning.